We need banks to fail more often – not less

Anthony J. Evans is associate professor of economics at ESCP Europe Business School in London, and Fulbright scholar-in-residence at San Jose State University. His website is www.anthonyjevans.com.

Anthony Evans

THE Independent Commission on Banking (ICB) has spoken, but not too loudly and with no real urgency. Even if its main recommendations are eventually adopted (such as ring-fencing the retail and investment arms of banks and raising capital requirements), few people feel that this will fix the banking sector’s problems.

Even if these measures work, the assumption that investment banking is more risky than retail banking not only oversimplifies the activities that banks are engaged in but also rests on a simplistic definition of risk. It suggests that risk is not only measurable but that we can choose how much of it to bear. I appreciate that this is standard portfolio theory, but it is wrong. We can’t say that one thing is more risky than another – only that different activities expose people to different types of risk. Bodies like the ICB needs to shift from trying to – impossibly – reduce risk to placing responsibility on those who are choosing between different risks.

For example, ordinary depositors should not be protected from risk – they need to confront it. It can seem counterintuitive, but the genuine threat of bank runs is probably the best disciplinary device to prevent them from happening. Regrettably, the ICB report failed to outline a banking system that would make bank failures more common and less catastrophic. I wanted to see more prominence given to how the payments system might survive a widescale liquidity crisis; the speed at which depositors might reclaim their assets in the event of a bank failure; and the legal safeguards (such as living wills) that show companies have thought about managing bankruptcy. Or – more importantly – the incentives to make it rational for banks to do this planning for themselves.

By making arbitrary decisions about what must stay within fences and what doesn’t, or about the level of equity capital that banks will be required to keep, regulators make banking more homogenous. Banks are already free to set up their own ring fences, and a competitive system would be one where they can experiment with different ones. It is convenient to believe that all banks failed during the credit crunch, but the reality is subtler. Some banks did better than others, and events vindicated those that abstained from ballooning lending funded through the short-term money market. That is their competitive advantage, and using regulations to deprive them of this opportunity to capitalise on it seems unfair. Just when the public begin to sit up and take notice of what their banks are doing, just when shareholders start to pay attention to what their money is being invested in, the regulators tell them to go back to sleep.

The bottom line is that risk cannot be reduced; it can only be transferred and disguised. All regulations create clusters of errors – by their nature they harmonise behaviour and therefore increase systemic dangers. Policy efforts need to focus on reducing barriers to exit, making it easier for banks to fail, making the costs of failure more visible and ensuring they fall on those who make bad decisions – bankers, regulators, or even the public.

Anthony J. Evans is associate professor of economics at ESCP Europe Business School in London, and Fulbright scholar-in-residence at San Jose State University. His website is www.anthonyjevans.com.